A minor heresy...

Far be it for me to disagree with the late, great Peter Bernstein, founder of the Journal of Portfolio Management, who once provocatively suggested that all companies should be forced to pay out 100% of their cashflow. Those companies requiring capital beyond their immediate operating needs would be obligated to go the markets and prove their point. As a Dividend Investor in a Stock Market, I’m not so strident. But as dividends make their return, greater flexibility in payment patterns would benefit management and investors.*

When dividends were in retreat in the US stock market over the past few decades, the format of payment didn’t matter much: quarterly, increased once per year, from a declining (now low but steady) number of S&P 500 Index companies. With the return of the cash nexus, minority owners in successful publicly-traded businesses can look forward to increased payments from a larger number and broader array of companies. This paradigm shift also provides a once-in-generation opportunity to consider the format of payouts to company owners. Right now, one size fits almost all. In an ideal scenario, we will end up with more varied arrangements.

The current standard approach, of annual increases of quarterly payments, generally works well for businesses with steady operations, a conservative balance sheet (hard to do over the past 40 years of dropping rates), and management committed to the exercise over multiple generations. But when several of those conditions fail at the same time, the “we must always raise our dividend every single year or bad things happen” approach leads exactly to bad things happening: poor capital allocation decisions, missed investment opportunities, eventual dividend cuts and management departures. While the minority investor desires the dividend handcuff placed on management to offset the enormous agency cost of fractional ownership of large modern corporations, at a certain point the handcuffs cut off the blood flow and limbs wither away. While that doesn’t happen often, it still behooves investors and corporations to have cash distribution options that allow companies some flexibility.

What’s wrong with special dividends? Absolutely nothing. They count toward total return and they deliver unneeded corporate cash to the owners of that cash, the shareholders. Do people complain about getting an annual cash bonus from their employer? No. And investors shouldn’t either. Company management teams don’t like paying specials because they feel that they don’t get “credit” in the stock market with a higher multiple or share price. I don’t care. They are a part of total return; they are part of a reasonable profit management system for companies that periodically—say every few years—build up excess cash. Next.

Fixed payouts can make lots of sense. Many companies say that they have a payout range that they want to observe, but if earnings are weak one year, they let the rate rise rather than break their string of dividend increases. Aristocrats are that way. They think about the past, not the present or future. And so the outflow increases and the company has fewer options in the future if business conditions do not improve. In contrast, a strictly observed payout ratio should help keep companies out of trouble. Let’s say it is 65% of last year’s net income. If that’s the rule, stick by it. If earnings are up, the dividend goes up. If they are flat, the dividend stays the same. If they are down for a year or two, the dividend burden is reduced by the same amount and the company lives to fight another day. More US companies should adopt this approach. Wall Street’s objection is the same tired one: the market punishes companies that cut their dividends, even if it is by a small amount and for a good reason. That objection belongs to the prior paradigm. It will ring less true in the upcoming one.

Mixing a fixed or slowly rising base dividend and an annual cashflow-dependent special dividend would seem to offer companies in cyclical businesses the means they need to preserve their businesses while still distributing profits to company owners. Energy, cyclical industrials, and many consumer discretionary businesses would be ideal candidates for this approach. (This approach has been adopted by energy companies now and again, often in Canada, but is not widespread in the US.) The market’s objection is not surprising: that this is a complicated method that is hard to forecast. Once again, that means the company’s stock won’t get credit or the high multiples it “deserves.” Perhaps that was the case under the prior paradigm, but with the return of the cash nexus, well-managed cashflows will be highly valued by investors.

Maintaining a steady aggregate dividend payment, while the per share amount rises over time. Several large companies do this at present. These are substantial companies already facing multi-billion dollar payouts. In the case of energy giant, Exxon, it is $14.9 billion per year in dividends. Quite rightly, Exxon doesn’t want to get in a position where it can’t afford its dividend. And growing the aggregate amount every year seems to invite that very problem. So instead, they buy back shares to reduce share count. By doing so, they can raise the per share dividend each year, without creating an additional burden on the company. This approach is only relevant for established companies facing very large numbers and with ample cashflow to manage their their share count. But it is smart and an instance in which buybacks that genuinely reduce shares outstanding can be appreciated by A Dividend Investor in a Stock Market.

There may be other variants that apply to individual industries and asset types. The goal is not a new one-size-fits-all approach. Having multiple payment forms maximizes the benefit of the cash nexus for both companies and investors. Here it is appropriate to point out a potential conflict of interest (or agency cost) of fractional minority share ownership. Company management teams view their stock as the investment. Hence their desire to smooth out returns and offer a constantly rising dividend in all environments. Corporations desire flexibility but feel compelled to act like a dividend aristocrat, whether or not it is leading them to the guillotine. In contrast, investors have the ability see their portfolio as the investment. That allows investors to select a variety of payment patterns and use simple diversification to achieve a more or less steady outcome. In short, it may be a while before companies get comfortable adopting more flexible payment patterns, and for investors to realize that not all companies have to raise by a fixed amount on the same day every year.

*Some weeks ago, I published a piece on the various types of stock buybacks one encounters in the US stock market. While The Dividend Investor in A Stock Market is usually competing with buyback dollars, it’s more complicated than that simple headline, and I tried to address that complexity from the side of buybacks advocates. In limited circumstances—far more limited than widely assumed—they have a role to play. (https://strategicdividendinvestor.com/an-academic-finance-fairytale-but-sometimes-it-works-out/)